JPMorgan: The cryptocurrency market looks like a pyramid scheme

JPMorgan (JPM) strategist Marko Kolanovic has some strong words for the cryptocurrency markets that are dominating the conversation right now, using the two words no one in the investing world ever wants to see: pyramid scheme.

“Cryptocurrencies cannot be reliably valued and they have significant ‘tail risk’ that could come in the form of a regulatory ban,” said Kolanovic in a note published Wednesday. “Moreover, the whole cryptocurrency market exhibits some parallels to fraudulent pyramid schemes.”

Most simply, a pyramid scheme is one in which members of a sales network are incentivized financially to grow the network instead of making sales. Pyramid schemes are illegal.

Literal pyramids.

Pyramid schemes are often associated with door-to-door sales networks. In 2012, Bill Ackman famously made a three-hour presentation arguing that multi-level marketing firm Herbalife (HLF) was a pyramid scheme and would go to $0; shares of Herbalife were trading near $70 on Wednesday.

In essence, Kolanovic is saying that the scarcity of bitcoin some evangelists cite as bolstering the cryptocurrency’s value actually illuminates the pyramid-like nature of the scheme. Because if it is unprofitable to mine new bitcoin, then it follows that new or prospective bitcoin buyers might ask whether they are really getting something of value in buying existing bitcoin or simply enriching the early owners who own a disproportionate amount of the asset.

Additionally, the proliferation of cryptocurrencies we’ve seen of late — Kolanovic estimates the market is now about $150 billion in size — indicates that players in the space may merely be extracting value from new members (read: crypto investors) and not actually creating cryptocurrencies which are worth anything.

Kolanovic writes that, in the case of bitcoin, “it is believed that an unknown person (or persons) known as ‘Satoshi Nakamoto’, before disappearing, mined the first 1-2 million coins, or ~10% of the coins that will ever exist ($4-8 billion current value). While initial mining requires a negligible effort, the benefits for subsequent participants start diminishing. Mining becomes progressively more difficult, and eventually unprofitable, marking the likely end of a scheme.”

Like a pyramid scheme, then, the values accrue up the chain while the losses flow down. Kolanovic says a possible workaround would be to just create a new coin, adding that, “This can work as long as there are enough willing and uninformed buyers.”

“Worse than tulip bulbs”

On Tuesday, Kolanovic’s boss Jamie Dimon — CEO of the Wall Street bank — said the bitcoin craze we’ve seen this year is “worse than tulip bulbs,” a reference to the tulip mania of the 1600s. Dimon added that, “if [JPMorgan] had a trader who traded bitcoin I’d fire them in a second. For two reasons: It’s against our rules, and they’re stupid. Both are dangerous.”

Critics of Dimon’s comments will note that Dimon both “doesn’t get” bitcoin and that, if bitcoin and related technologies are going to undermine the primacy of the modern banking system, he would of course dismiss it.

Investment manager Patrick O’Shaughnessy also said Tuesday that after a presentation on value investing delivered to a room of investment industry pros, the first question was about bitcoin.

Betting on Bitcoin is Wall Street’s most crowded trade right now.

The technology that enables bitcoin

Now, those steeped in the cryptocurrency space will say that the price of bitcoin — currently down 6% on Tuesday to around $3,900 but still up about 300% this year alone — is not as relevant as the blockchain technology underwriting bitcoin.

A blockchain is a distributed, immutable ledger for recording data or executing smart contracts — effectively a set of characters unique to a transaction executed on the blockchain. And so the enthusiasm around bitcoin is largely an enthusiasm around our transactions moving to execution via blockchain rather than, say, through existing financial institutions.

And as Kolanovic writes, “Developments arounds distributed ledgers and the concept of digital currencies are fascinating from a technological point of view. It is likely that some of these technologies will become very valuable.”

Bitcoin just might not be the thing that matters.

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Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland